Anthony Hilton: How City missed Tesco’s fall from grace

Tesco has had a rough few days since the management announced that it had overstated its anticipated profit by £250 million. City fund managers and analysts in particular are shocked. The shares are lower than they have been for a decade.

But why were they surprised? If analysts had focused more on corporate culture and less on predicted numbers, they might have had a better understanding of the dynamics of the business. They might even have realised that it was being run in a way that made this kind of thing a possibility.

There have long been things in Tesco’s behaviour and business model that did not seem sustainable, and were possibly even toxic, but have nevertheless taken years to make the whole business sick. It is arguable the interesting thing about Tesco is not that its profits have collapsed but that they stayed a high as they did for so long.

Companies are about people, not numbers, and the clues to these now-obvious problems could be found in the company’s reputation. This was stellar in the City because analysts will tell you the foundation of a great corporate reputation is the ability to grow market share and profits year after year. But the customers, suppliers and communities where the company operates had a different perspective. Tesco’s reputation with these stakeholders was sometimes rather a contrast.

While it was expanding to the delight of its investors, Tesco was becoming a pariah in local communities. Rightly or wrongly, in many places they did not want a supermarket because they felt the social and business impact in the town or village where they lived would outweigh the benefits. But they got one anyway. The Tesco planning machine never took no for an answer. Most local authorities were worn down or legally bought off in the end.

It had to be thus because expansion was crucial to the business. What set Tesco apart was not its offer to the customers, the range of its products or the price at which they were offered. It grew remorselessly because it had a machine that could build more stores in better locations than any of its competitors. Then the internet turned this plus into a minus almost overnight.

When people began to shop online Tesco suddenly had too much space. Its business model became obsolete overnight. At the same time, Tesco’s treatment of its suppliers was causing increasing concern. City analysts probably never met the growing number of customers who refused to go to Tesco because of what it was doing to farmers, or what the customers thought it was doing. If they had, they would probably have lauded it as an example of supply-chain efficiency. But they ought to have asked more vigorously why it was that, while no supermarket was a saint in this area, it was Tesco that bore the brunt of the criticism.

Analysts don’t come from the planet Zog, and that is a pity because it means they find it hard to think outside the box. A visitor from Mars would have looked at these signs of alienation in communities, of customers and of suppliers and think that Tesco had a problem — that this was not a sustainable model and that sooner or later these issues would come together to undermine the business. But not so the City; it could not see past the numbers.

Tesco itself never seemed to think these issues through either. Like City firms that see fines from the regulator as a cost of doing business rather than a sign there is something fundamentally wrong, it rationalised it. Its clouded reputation was only with minorities, and was more than offset by the benefit it delivered to shoppers overall. The City bought that — perhaps because most fund managers tend to hold shares for a relatively short time, less than a year, and therefore feel no particular need to focus on a potential long-term problem.

A more considered approach might have been too see these hostilities as a sign of a business under pressure — a business straining too hard to deliver growth, and becoming ever more willing to brush aside those who sought to interfere with its vision. Yet it is that kind of pressure, the way middle-ranking employees respond to an over-demanding tone from the top which gives rise to corporate disaster, be it phone hacking in a newspaper group, or mis-selling PPI in a bank.

In Tesco’s case, it was horse meat. It was presumably never top management’s intention to pass off horse meat as beef, but a culture was created in which suppliers came to think such behaviour was acceptable. The objective of the business had become the delivery of its growth targets, not the fair treatment of its customers. In this latest episode, the new chief executive has found that the company has been severely overstating its profits. The City asks how this could happen when it should ask how it missed or failed to heed the warnings implicit in all the other signals, because this is simply the most extreme manifestation of behaviour patterns that have been visible for years.

It might also reasonably ask whether this overstatement of profits is something that has only just happened. After all, if the pressure to perform has been there for years, it follows that the pressure to overstate profits might also have been there for years. How can Tesco’s new chief executive, a stranger to the firm’s culture, be sure even now that his subordinates are telling him the truth? History teaches us that there could be more to come. This has the potential to be really unpleasant.

When the pressure to perform becomes intolerable, good people will often do bad things. It is the culture which is bad, not the people. But it is high time that investment managers, who charge the public for their expertise and judgment, paid more attention to that culture.